CONVERTING INVESTMENT PROPERTY TO PRINCIPAL RESIDENCE? NEW LIMITS ON GAIN EXCLUSION!
Do you plan to convert an investment property into your personal
residence? The Housing Assistance Tax Act of 2008 that President Bush
signed into law on July 30, 2008 carries a provision that affects the
practice of excluding gain when you sell a property that was once used
for another purpose, such as a rental property, and then converted into
your personal residence. The effect of the new law is a restriction on
the amount of gain you can exclude through Section 121, the personal
residence exclusion section of our tax code.
Section 121 of the Internal Revenue Code allows a gain of up to $250,000 ($500,000 if you are married and
file jointly) with no tax obligation when you sell a house used as a
primary residence for two of the previous five years. You don't even
need to occupy the property for two consecutive years during the five
year period; just two years out of the five in any form.
As of January 1, 2009, the new law
reduces the amount of gain that you can exclude if you have used the
property for any purpose other than as a primary residence. The
reduction is applied on a pro rata basis by determining the percentage
of years the property is not used as a primary residence purposes to
the total years the property is owned by the taxpayer.
Sometimes examples help clarify things. Here's one: a married couple
acquires a house that they use as a rental in 2009. The couple rents
the house for four years, and then moves into it and uses it as their
primary residence for the next two years. The couple sells the property
at the end of year 6 with a gain of $300,000. Applying the old law, the
couple would be eligible for the full $500,000 exclusion and would owe
no tax. The new law requires the application of the proration described
in the paragraph above. Two-sixths (two out of six years) of the gain,
or $100,000 would be eligible to be excluded.
Exceptions to New Law:
A couple of interesting exceptions to this new restriction exist.
First, periods in which the property is not used as a primary residence
that occur prior to January 1, 2009 do not reduce the excludable gain.
Using the example provided above, if the three year rental period
occurs prior to January 1, 2009, the exclusion would not be reduced and
the couple would be able to exclude gain on the sale up to the full
A second interesting exception is if you convert property that you
first used as your primary residence into investment property, it will
not be affected by this new law. By way of example, consider this
scenario: you own and live in a house for eight years, at which time
you move out and rent the house for two years before selling it. Since
your investment use of the property took place after your use as a
primary residence, all of the gain accumulated over your 10 year
ownership of the property can be excluded up to the $250,000/$500,000
There are also some limited exceptions for taxpayers who serve on
"qualified official extended duty" or are temporarily absent due to
changes of employment, health conditions or other unforeseen
circumstances. Individuals in those situations should have their tax
advisors review the new law to determine whether the exceptions could
be of benefit to them.
Combining Exclusion with 1031 Exchange
One thing that did not change is the requirement to own property for
at least five years if you acquire it in a 1031 exchange and
subsequently convert it to your primary residence before it is eligible
for the Section 121 exclusion.
If you convert your primary residence to an investment property and subsequently sell the
property, you should be eligible to combine your Section 121 exclusion
with a Section 1031 tax deferral for the gain that is not excludable
under Section 121.
Hopefully this did not make your head
spin too much. It is clear that some complicated situations could arise
out of the application of this new law. Advance planning through
consultation with your tax advisor is a must. The inclusion of a
knowledgeable exchange expert in the planning process would be equally